How credit card issuers pay rewards without going broke
This is a guest article by Lance, the founder of the blog Money Life and More. Earning rewards from credit card companies like cash back and sign-up bonuses, astute credit card users may be wondering how issuers afford to pay these bonuses for people who don’t pay interest or late fees. Lance takes a look at this feat.
Credit card companies have been offering some pretty awesome rewards and sign-up bonuses recently. I personally have made almost $1,000 in credit card rewards last year, much of which came from sign-up bonuses. On top of that, I received cash back rewards from all of the credit cards I use on a regular basis.
Just so you can get an idea of some of the rewards I get…
With my Chase Freedom® card, I earn 5% cash back on up to $1,500 in combined purchases in bonus categories each quarter I activate. The categories usually change every quarter. In addition, there is unlimited 1% cash back on all other purchases.
I also have a Chase Sapphire Preferred Card that gives me 2% cash back on travel and dining and 1% cash back on everything else. It came with a 40,000 point sign up bonus after spending $3,000 in the first three months after opening my account. My last cash back card offers 1% on all purchases up to a spending limit of $10,000 a year and then pays out 1.5% cash back on everything else.
The credit card companies pay out a ton of money in rewards every year, but how do they pay for it? It helps to look at the problem of these reward programs from the credit card companies’ perspective before jumping right into how the credit card companies pay for it all.
The biggest potential problem about credit card rewards programs is that freeloaders take advantage of the offers.
I am freeloader and I want you to be a freeloader too! If you aren’t a freeloader you absolutely should not be using these credit cards as they normally come with higher interest rates than a credit card without rewards. So what exactly is a freeloader?
A freeloader is someone who takes advantage of these credit card reward programs. They receive the awesome sign up bonuses and cash back offers that accompany the programs without providing any revenue for the credit card companies. Freeloaders always pay their balances off in full every month and never pay a dime (or even a penny) of interest. They never pay a late fee. They know their credit card rewards and fee schedules inside and out. They make sure they follow all the rules to never pay the credit card companies anything more than the purchase price of all of their transactions.
Some cards even have annual fees that are waived the first year. Most of these freeloaders will either get the fee waived in subsequent years or cancel their card. Some freeloaders won’t do this because the value of the rewards exceeds the annual fee, but I’d say the vast majority cancel or get the fee waived. They are freeloaders after all.
So if freeloaders exist, how do the credit card companies pay for the rewards?
If you have credit cards and you aren’t a freeloader then you’re paying the credit card companies (and the freeloaders) in one form or another. You could pay the annual fee, a late fee, a balance transfer fee, an over-limit fee, interest or any of the other fees and charges that credit card companies rely on for revenue. It doesn’t matter how the credit card companies get your money. The simple fact is they do get money from their customers and lots of it!
You must first meet many conditions in your credit card agreement in order to receive the rewards. Normally your account cannot be delinquent and you have to hit a certain points or cash back threshold before you can redeem your rewards. If you never meet those conditions you may never get paid those elusive rewards.
Consider these mind-blowing statistics:
- The average APR on a credit card with a balance on it was 12.81% in November 2012 (http://www.federalreserve.gov/releases/g19/Current/)
- Total outstanding revolving debt was $850.8 billion. (http://www.federalreserve.gov/releases/g19/Current/)
- 56% of consumers have carried a balance within the last 12 months. (http://www.statisticbrain.com/credit-card-debt-statistics/)
- Only 40% of cardholders have credit card balances of less than $1,000. (http://www.statisticbrain.com/credit-card-debt-statistics/)
The interest that credit card companies collect could probably pay for all of the rewards multiple times over before you factor in any of the fees or other revenue sources.
Other major expenses of credit card companies
There are other expenses that credit card companies must deal with that possibly cause a much larger impact to their profits than paying rewards. Delinquent accounts are big headaches for credit card companies. If the companies never collect on a delinquent account they lose both the principal and interest owed to them for that account. The other option is to sell the account to a collections company for as low as pennies on the dollar.
Credit card fraud and identity theft are more big headaches for the credit card companies. I was a victim of credit card fraud myself. I thought I was lucky, and that the fraudster had only gotten away with a $19.95 order of Proactiv acne cream. Unfortunately I was wrong, and the issue expanded beyond just credit card fraud, and I was a victim of identity theft. The thief initiated a balance transfer for over $3,000, and if I hadn’t caught it as fast as I did the credit card company would likely have lost every penny of it.
One last thought
Credit card companies offer these stellar rewards programs for a reason. That reason is to bring in more customers and make more money! If they didn’t work, credit card companies wouldn’t offer them. How do I know that?
Credit card companies are businesses. They still make a ton of money after paying out the credit card rewards, covering delinquencies and writing off the charges made from cases of fraud and identity theft. Don’t feel bad for taking advantage of these rewards offers. If you can get the rewards and bonuses without paying the credit card companies a dime you’re doing great in my book.
Editor’s note. To expand on the above, credit card companies aren’t losing money by offering rewards, even when you consider just the freeloaders. Offering rewards encourages customers to spend more, and with every swipe of the card, the financial industry profits from interchange fees. The bottom line is that the money spent on marketing expenses, including sign-up bonuses and rewards expenses, are more than worthwhile. I can’t imagine a typical consumer is worried about how the credit card companies are able to generate profits when paying out $100 to $300 per rewards customer per year; this is a tiny expense for an industry with oversized profits.